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After a year and a half of falling oil prices, the downturn’s rippling effects have spilled over into energy related CMBS loans. Based on our analysis, we have identified $684 million of CMBS 2.0 oil exposed loans and REO in Kroll Bond Rating Agency (KBRA) rated (21 ) and non-rated transactions (7) that have been designated KBRA Loans of Concern (K-LOCs). K-LOCs include specially serviced and REO assets as well as non-specially serviced loans that are at a heightened risk of default in the near term.

In its ongoing monitoring process, KBRA has placed increased scrutiny on identifying and monitoring loans in energy driven markets. The time lag between declining oil prices and commercial real estate fundamentals appears to have run its course, particularly in the Bakken Shale Region of North Dakota. As a result, KBRA has been refining its property valuations and loss estimates considering current and expected market conditions in the region. The estimates also factor in costs and expenses associated with liquidating the collateral.

KBRA identified 37 CMBS 2.0 loans and one REO across 28 CMBS transactions with collateral located in oil and gas related markets. The details of these individual assets, as well as our loss estimates, are listed in the Appendix. Properties secured by 24 of the loans and one REO are located in North Dakota, and 11 are in Texas. In addition, two loans are collateralized by properties in Colorado and Oklahoma. By state, the largest loss exposure is in North Dakota where the majority of the assets are found in the Williston and Dickinson markets.

Of the 38 K-LOCs, 30 were assigned estimated losses totaling $162 million. In the aggregate, for the K-LOCs with losses, the weighted average loss severity is 54.3%. Loss estimates were as high as 87.9%, with North Dakota ranging from 23.8% to 87.9% (weighted average of 63.7%) and Texas from 7.4% to 29.3% (weighted average of 17.9%). The largest loss severity was associated with the North Dakota Strata Estates Suites REO asset, which represents 1.9% of the COMM 2013-CR10 transaction. The trust collateral includes two corporate housing projects that at issuance had 77% of the units leased to energy related companies.

The other eight K-LOCs included six from Texas and one each from Colorado and Oklahoma. K-LOC status was assigned to six office properties with oil related tenants, as well as two hotels which generate business from the energy industry. Although, losses were not assigned at this time, the loans are at increased risk of default, as energy related companies reduce their workforce, which in turn impacts their space requirements as well as room night demand for hotels.

Additional information on the K-LOCs and assigned losses are available on our KBRA Credit Profile (KCP) Portal (kcp.kbra.com), a proprietary service that performs monthly transaction monitoring for much of the CMBS universe.

Multifamily and Lodging Most Affected

Oil related economies and companies have been contracting, thereby reducing demand for workers and investments in oil exploration and production. Most affected have been those areas with a high concentration of workers in energy-related jobs. According to the US Department of Labor, North Dakota’s oil and gas employment accounted for 4.8% of its workforce (see Chart 1). As a result, with oil’s plunge, North Dakota’s mining and logging employment growth, most of it related to oil drilling, has turned sharply negative (see Chart 2) on a year-over-year basis. Most impacted has been the Bakken Shale Region as production has slowed and oil rigs idled. Although, this region makes up only a small percentage of the CMBS population, KBRA’s loss estimates for K-LOC’s in this area are fairly high. Furthermore, they have the potential to increase if the global oil glut continues for an extended period.

By property type, most affected have been the multifamily and lodging sectors. Due to their short term leases they adjust to downturns much more quickly than the other major property types. Multifamily properties typically have fairly short term leases (one year or less) when rents can be adjusted, while lodging room rates can change daily. Individual K-LOC losses run as high as 87.9% and 63.4%, respectively for these two property types. In total, the loss severity is 71.1% for multifamily and 38.6% for lodging. Employment losses have led to less demand for apartments in the energy dominated markets, while new projects continue to come on line and add to existing supply. Energy related companies in these markets have reduced or eliminated corporate leases while laid off workers migrate to other states for employment opportunities. In one of the most affected markets, Williston, multifamily asking rents have declined from approximately $2,100 to $1,500 year-over-year through December 2015 according to our review of CoStar Group data. Other third party sources including Apartment Guide indicated that this figure could be lower.

With the demand for lodging, new hotels opened to help handle the flood of oil workers. Not only are the more oil dependent economies experiencing declining hotel occupancies and rates, but due to its exposure to the oil and gas business, Houston lodging has experienced weaker demand. According to Smith Travel Research (STR), on a full year-over-year 2015 comparison, Houston’s RevPAR fell by 3.3% primarily the result of lower occupancies. For all US markets, RevPAR increased by 6.3% during the same period. Vacant office space is also increasing in Houston, as companies reduce their space requirements through lease terminations, nonrenewal of expiring leases, and sublease of their excess space. We have identified $217 million of Houston office loan collateral that were assigned K-LOC status.

For the other major property types, retail is expected to be impacted especially in markets where there have been major employment losses, with fewer shoppers to support existing centers. Warehouse space may also come under pressure especially for facilities used for storing oil drilling supplies and equipment.

KBRA believes that the fallout from the oil decline will mostly be confined to those properties in energy related markets. However, in these and other markets, CMBS collateral with tenants that are primary and ancillary suppliers to the energy sector may ultimately succumb to the downturn’s persistence.

With real estate markets having rebounded from the latest bust, lenders are once again funding major renovations, including rehabilitation projects that benefit from federal historic preservation tax incentives. A lucrative (but complex) program for developers and tax investors since inception in 1976, historic tax credit (HTC) projects had returned to favor following the Financial Crisis of 2008. While an appellate court decision sent a chill through the market in 2012,[i] a new set of IRS tax guidelines applicable to HTCs at the beginning of 2014 has set the groundwork for HTC projects to flourish once again. The lender who understands the intricacies of HTCs will have a clear advantage in an arena that promises attractive opportunities in the coming years. This primer on HTCs offers a starting point to such an understanding.

THE PROGRAM

The HTC program, administered by the National Park Service (NPS) in conjunction with the applicable State Historic Preservation Office (SHPO), provides for a reduction in, and a credit against, federal income taxes of up to 20% of the cost of rehabilitating certified historic structures[ii]. The HTCs, claimed in the year rehabilitation is completed, remain subject to recapture if it fails to meet the program’s ongoing requirements during the ensuing five-year period. While most real estate developers do not have sufficient income to fully utilize the tax credit, developers may pass HTCs through to high-income tax investors that do[iii]. The transaction may not be structured as a sale of HTCs; instead the tax investor must become a partner in the real estate transaction.[iv] Still, HTC transactions are typically structured to provide the tax investor a financial incentive to sell its interest back to the developer at the conclusion of the recapture period.

Developers and tax investors typically utilize one of two distinct deal structures:

Single-Tier Structure. In the single-tier structure, the tax investor is admitted as a partner of the property-owning entity (which is entitled to claim the HTCs).

Master-Lease Structure. The property owner leases the property to an entity owned at least 99% by the tax investor[v]. The master lessee in turn obtains a 10% stake in the property owner. The property owner incurs the qualified rehabilitation expenditures but is permitted to pass the HTCs to the master lessee, and to the tax investor through its interest in the master lessee.

The advantages of the single tier tax structure are its simplicity and lower transaction costs. The master lease structure, on the other hand, has the advantages of not reducing the property owner’s basis in the property by the amount of the HTCs and permitting the developer, rather than the tax investor, to claim depreciation. It also permits the developer greater control over the property’s cash flow. Another benefit of note to lenders in a master-lease structure is that foreclosure will not result in a termination of the master lease, so long as the parties have entered into a subordination, non-disturbance and attornment agreement (SNDA), and therefore is generally not a recapture event.[vi]

HISTORIC BOARDWALK AND NEW THE GUIDELINES SUGGEST ROBUST RETURN OF HTC MARKETPLACE

Just as the economy was rebounding from the latest recession, a federal appellate court in New Jersey issued a decision in 2012 that stalled the market’s revitalization.[vii] The court’s ruling in Historic Boardwalk Hall LLC v. Commissioner, 694 F.3rd 425, held that the tax investor lacked a meaningful stake in the success or failure of the partnership owning the property, and therefore not a bona-fide partner in the transaction and consequently not entitled to claim its HTCs. The ownership structure utilized in the Historic Boardwalk case was sufficiently typical of the way HTC deals were being structured to significantly dampen the market for new HTC deals. The widespread backlash resulting from the Historic Boardwalk case, however, led the IRS to issue Revenue Procedure 2014-12 on December 30, 2013 and a clarification on January 8, 2014 (collectively, the Guidelines), describes a “safe harbor” for structuring new HTC transactions. With the safe harbor in place as a guide post, the expectation is that the industry players will return to the market[viii]. As the tax experts work through the kinks in the Guidelines, and successful structuring precedents are established, many anticipate the HTC market to return unabated.[ix]

The Guidelines’ overarching requirement is for the tax investor’s partnership interest to “constitute a bona-fide equity investment with a reasonably anticipated value commensurate with the investor’s overall percentage interest in the partnership”[x], without taking tax attributes into account. The tax investor’s economic interest may not be reduced by unreasonable developer fees, lease terms or other arrangements, a test necessitating a comparison with non-HTC transactions. Underwriting based on non-HTC transactions has increased as a result. Most transactions are structured conservatively until a consensus develops as to the practical limitations of the “commensurate rule” and to how much leeway the IRS and courts are likely to permit. The tax investor must fund at least 20% of its capital contribution before the property is placed into service. The developer is required to maintain at least a 1% interest and the tax investor to maintain at least 5% of its largest percentage in each material item of partnership gain, loss deduction and credit, meaning that after the recapture period the tax investor’s partnership interest can be structured to automatically flip from 99% to 5%, thereby creating an incentive for the tax investor to exit at the end of the recapture period.[xi] The Guidelines sought to eliminate certain forms of developer guarantees including most notably a guaranty of the tax credits themselves. The inability to obtain a guaranty of the HTCs, as before, is expected to result in stricter underwriting of transactions by tax investors. Guarantees may not contain minimum net worth covenants. As a result, look for tax investors to “piggyback” upon lender net worth requirements.

HTC PROGRAM BENEFITS TO LENDERS

Because HTCs are personal to the entity that originally claimed them, HTCs are not part of the lender’s collateral. Although the lender does not benefit directly from HTCs, it can still receive significant indirect benefits from lending on an HTC project.

The tax investor’s very involvement in the transaction can be a source of comfort to the lender in that the tax investor will add its own underwriting and oversight requirements to the transaction. The project will also require certification by the NPS and SHPO, which provide another layer of oversight. Further, the Guidelines now require that all fees payable to the developer and its affiliates be reasonable.

The capital structure also will benefit from the tax investor’s involvement in the transaction. The tax investor typically infuses large amounts of funds prior to construction reducing the potential for the project ending up “out of balance.” Moreover, the tax investor’s equity must remain in the deal for at least five years after completion of the renovations, helping to reduce the loan-to-value ratio of the project and the need for other forms of risky capital, such as mezzanine financing.

ISSUES FOR THE LENDERS ON HTC PROJECTS

A lender foreclosing on a project that has benefited from HTCs is not subject to any state or federal restrictions specific to HTCs. However, the prudent lender will still need to address certain issues relating to HTCs. We have outlined below a few of the more salient issues that lenders may face.

SNDA

If the master-lease structure is utilized, the relationship between the tax investor and lender will be governed by an SNDA. The primary effect of the HTC SNDA is to subordinate the master lease to the lien of the mortgage in exchange for the lender’s agreement not to terminate the lease following a foreclosure, a concession which the tax investor will require in order to avoid a resulting recapture event. In fact, the tax investor will often insist that the lender agree not to terminate the master lease even if the master lessee is in default under the master lease, a so-called “standstill” or “SNDA-on-steroids” provision.

While the steroids provision at first glance appears objectionable to the lender, agreeing to such a provision in exchange for a concession from the tax investor may make strategic sense. For example, in an SNDA with an office or retail space tenant, the lender-post foreclosure-could be faced with a non-rent-paying tenant. In this situation it is essential that the lender has the right to terminate the lease and remove the tenant. However, with an HTC master lessee, there is no real chance of the master lessee committing a material default since the master lessee is merely a pass through entity for the property’s real economics and because the lender, in any event, will be able to foreclose on the developer’s pledge of the managing member interest in the master lessee and thereby cause the master lessee’s compliance with the master lease[xii]. Regardless, the lender should insist on the right to terminate the master lease once the recapture period has expired.

For its part, the tax investor will want to prohibit the transfer of the property through foreclosure (or deed-in-lieu of foreclosure) to a disqualified transferee. Such a transfer could result in a recapture event or loss of credit. The lender, meanwhile, will want the freedom to foreclose and to further transfer the property. A frequent compromise is to permit the lender to foreclose in exchange for an agreement that any subsequent offer to purchase the property made by a disqualified transferee will trigger a right of first refusal for the tax investor.

The lender needs to obtain a release from any liability for the developer’s obligations to the tax investor should the lender foreclose on the developer’s pledge. If the tax investor insists on its own right to remove the developer as managing partner of the master lessee, the lender should limit such replacements to cases involving the developer’s willful misconduct, fraud or other malfeasance and require the tax investor to supply a replacement managing partner with the requisite operating experience.

2. AT RISK RULES

The IRS “at-risk” tax regulations provide that the amount of a project’s non-recourse financing cannot exceed 80% of the credit base of the qualified rehabilitation expenditures. If a proposed non-recourse mortgage loan will push the project beyond the 80% threshold, there are steps the prospective lender can take to avoid a potential loss of HTCs? One solution is to have the master lessee, in its capacity as a partner of the property owner, assume any deferred developer’s fee[xiii], thereby removing non-recourse financing in the amount of the fee from the property owner’s balance sheet (the assumption of the fee would then be treated as a capital contribution to the property owner by the master lessee). Alternatively, the developer could guaranty a portion of the mortgage loan (thereby making that portion recourse) in an amount sufficient so that the “at-risk” rule is not violated. Before accepting such a guaranty, however, the lender should assess the bankruptcy consolidation risk created by obtaining a guaranty from an affiliate of its borrower.

At first glance, the complexities created by master leases, SNDAs, “at-risk” rules and other aspects of historic tax redevelopment projects and the tax regulations that govern them may appear to the lender more like a sentence to prison confinement than an avenue for exploration. But, the lender willing to master the finer points of historic tax credit transactions may very well find itself at the forefront of an already established market now ready to explode with new possibilities for fruitful exploitation.

[i] According to the U.S. Department of the Interior, since its inception the HTC program has been utilized in over 40,380 completed projects worth approximately $73,000,000,000 (as of fiscal year end 2014).

[ii] Many states offer a similar historic tax credit program to the federal program. Although, we limit our discussion to the federal program, many of the issues and benefits are applicable to most or all of the state programs as well.

[iii] A small cadre of large corporations, such as Chevron and Bank of America, are the usual players in the HTC market.

[iv] For ease of drafting and readability, we refer throughout this article to “partners” and “partnerships” but the HTC rules apply equally to limited liability companies and their members.

[v] The master lease must be for a term of at least 80% of the length of the applicable recovery period, which means for commercial properties a term of at least 32 years.

[vi] A transfer to a “disqualified transferee” could still result in a recapture but the set of “disqualified transferees” is essentially limited to tax exempt organizations such as governmental entities, foreign persons and REITs.

[vii] According to the U.S. Department of the Interior, approved HTC applications declined by nearly 25% over the three year period commencing in 2009. By 2013, according to the NPS, the number of approved projects had risen to 1,155 (representing approximately $6,730,000,000 in project costs), a healthy but not spectacular 26% increase over 2012—the enthusiasm for HTCs that arose with the return of a robust real estate market having been dampened by concern over the implications of the Historic Boardwalk decision.

[viii] According to the Journal of Tax Credits published by Novogradac & Company LLP (February 2014 Volume V, Issue II, pg 3), “HTC investors interviewed shortly after the issuance of the [Guidelines] were generally positive [and]…believed they would come back into the market.” Developers interviewed for the article also generally supported the notion that the Guidelines would encourage developers to do HTC transactions.

[ix] According to the U.S. Department of the Interior, the number of approved HTC projects in 2014 was almost exactly the same as 2013, as many of the market players would not embark on new deals until the tax experts had worked through the finer details of the Guidelines.

[xi]The Guidelines prohibit the developer from obtaining a call option to acquire the tax investor’s interest at the end of the recapture period, a favored form of protection utilized by developers prior to the issuance of the Guidelines. However, the significant reduction in ownership interest at the end of the recapture period should be sufficient incentive for the tax investor to exit the deal of its own volition.

[xii] The lender will typically receive a pledge of the developer’s interest in the master lessee.

[xiii] HTC deals typically contain large deferred developer’s fees since, in addition to being income to the developer, these fees may be included within the tax base and thereby increase the amount of the HTCs available to the tax investor. Although the tax regulations are not clear on the point, many experts believe that a deferred developer’s fee should be included in the calculation of non-recourse debt.

At numerous conferences this year, including the Commercial Real Estate Finance Council (CREFC) Annual Conference in New York, one particular topic has remained at the forefront: global capital requirements, which have the potential to become impediments to providing financing via securitized products. Just based on how much time was spent on the subject at these events, we believe that regulatory treatment of certain instruments is and will become a key driver of investment demand and liquidity in the coming years versus any typical collateral analysis investors currently consider.

Of particular investor focus recently are various regulators’ evaluations of what actually constitute “high-quality” liquid assets in order to calculate the Basel III liquidity coverage ratio and the associated market value haircuts. This topic has transcended international borders, as regulators seem to have interpreted what “high-quality” and “liquid” mean through somewhat of a national policy lens, perhaps without knowing the impact of decisions made in other countries. As a result, there is still uncertainty as to what final standards may emerge for global institutional investors, as rules will likely be further adjusted.

What Are The LCR And HQLA?

As part of Basel III, regulators designed the Liquidity Coverage Ratio (LCR) to ensure that banks have enough high-quality liquid assets (HQLA) on hand to cover the total net cash outflows over a prospective 30-calendar-day stress period. The ratio has total HQLA as the numerator and net cash outflows as the denominator.

Each nation has divided potential HQLA into three levels, 1, 2A, and 2B, with increasing market value haircuts applied to the HQLA assets based on the level, in an attempt to allow for fire sale-like liquidation conditions that could occur in an economic crisis. Additionally, the levels include some general caps on the total percentage of assets and certain types of assets that can be held. Under the general regulations, most level 1 assets may be included with no haircut, level 2 assets receive a 15% market value haircut, and level 3 are haircut by 25%-50%, although different instruments in each level may have varying haircuts.

(c) Securities issued by or unconditionally guaranteed as to timely P&I by the U.S. Treasury.

(d) Liquid and readily marketable securities guaranteed by any other U.S. government agency.

(e) Certain liquid and readily marketable securities that are claims on, or claims guaranteed by, a sovereign entity, a central bank, the Bank for International Settlements, the International Monetary Fund, the European Central Bank, and European Community, or a multilateral development bank.

(f) Certain debt securities issued by sovereign entities.

Securities issued under the National Housing Act Mortgage Backed Securities (NHA MBS) program may be included as level 1 assets.

For non-foreign non-DSIB institutions, holdings of NHA MBS and CMBS where the minimum pool size is less than $25 million may be included as level 1 assets.

Sovereign and central bank debt securities, even with a rating below ‘AA-‘, should be considered eligible as level 1 assets only when these assets are issued by the sovereign or central bank in the institution’s home country or in host countries where the institution has a subsidiary or branch.

(b) Certain obligations issued or guaranteed by a sovereign entity or a multilateral development bank.

Covered bonds that were issued by Canadian institutions before the Canadian covered bond legislation coming into force on July 6, 2012, may be included as level 2A assets if the other requirements are met.

Sovereign and central bank debt securities rated ‘BBB+’ to ‘BBB–’ that are not included in the definition of level 1 assets may be included in the definition of level 2B assets with a 50% haircut within the 15% cap for all level 2B assets.

Institutions are permitted to include long cash non-financial equity positions held against synthetic short positions as eligible level 2B assets provided certain operational requirements are met.

*Based on our read, the Canadian regulations are built on the EU regulations. We’ve included what we believe to be the relevant OSFI notes. †Our understanding is that an ECAI 1 rating is equivalent to a ‘AA’ or ‘AAA’ category, while ECAI 2 is ‘A’, ECAI 3 is ‘BBB’, ECAI 4 is ‘BB’, and ECAI 5 is ‘B’. P&I–Principal and interest. CMB–Canada mortgage bond. ECAI–External Credit Assessment Institutions. ECB–European Central Bank. IG–Investment grade. GSE–Government-sponsored enterprise.

One topic causing consternation among many market participants at the recent conferences was just how much the treatment of the constituent assets differed across jurisdictions. Currently, both the EU and U.S. versions of the rule include corporate bonds as level 2B HQLA. The EU regulation includes certain RMBS, auto loan ABS, small to mid-size enterprise (SME) loan ABS, and consumer loan ABS as level 2B HQLA, whereas the U.S. regulation does not.

Interestingly, the Canadian rules recognize the credit quality and liquidity that comes from their government-sponsored guarantee on their Canada Mortgage and Housing Corp. (CMHC) residential mortgage bonds as level 1 assets, while U.S. agency MBS is classified as level 2A under the U.S. rules. Based on our conversations with institutional investors, most are surprised and concerned about that decision. There are over $7 trillion in agency MBS outstanding (including in collateralized mortgage obligations [CMOs]), making it the third-largest bond class available to investors (U.S. Treasuries and U.S. corporates are the two largest). Also, average daily trading volume suggests that agency MBS is the second-most-traded fixed-income product after Treasuries, and has been for at least the past 10 years. It is understandable that U.S. regulators may want to distinguish between an implied and full-faith-and-credit guarantee by the government, but there may be an unintentional effect on the global bond ecosystem if investors begin to trade out of the $7 trillion agency bond market en masse and into the limited number of other potential alternatives, which would be the $12 trillion U.S. Treasury market or the less liquid, but still large, $8 trillion corporate bond market. This is especially true for domestic bank investors, who are currently the #1 holder of Agency/GSE-backed securities, and have increased their holdings since 2009 (see appendix).

Beyond the issue of deciding what is liquid and high-quality, there are valuation haircuts that are applied to HQLA (although generally not to level 1). On this issue, the EU regulations apply a 25%-35% haircut to their qualifying RMBS/ABS securitizations. This is below the 50% haircut for some other 2B HQLA, suggesting that the EU regulators may be recognizing that securitized products can help support their financial institutions and play a role in funding economic growth.

While not yet fully implemented, these levels, which include some bond products and exclude others, are already becoming a key factor in influencing bank investment demand as opposed to assessing credit risk and liquidity relative to yield. Based on conversations with institutional investors, a covered bank may invest in an EU SME loan ABS or auto loan deal versus a U.S. collateralized loan obligation (CLO) or auto loan deal based solely on the preferential regulatory treatment.

Further, it appears that commercial mortgage-backed securities (CMBS) are excluded in all jurisdictions from qualifying as HQLA. This exclusion is likely playing a role in the limited reemergence of floating-rate shorter-duration CMBS, as that market has not seen the same recovery achieved in fixed-rate CMBS. In Europe, CMBS does not meet several of the 14 criteria recommended by the BCBS-IOSCO task force to be classified as a “simple, transparent, and comparable” securitization. These include: nature of the assets (assets backing CMBS transactions typically are heterogeneous, not homogenous), consistency of underwriting (CMBS underwriting standards can and sometimes will vary by loan circumstance, e.g. acquisition or refinancing, stabilized versus non-stabilized property), and redemption cash flows (the majority of principal cash flows in most CMBS depend on refinancing or sale of the assets at maturity). In addition, CMBS do not meet other “high-quality” securitization (HQS) guidelines published by the EU Banking Authority (see endnote), which include a credit risk criterion that limits maximum obligor exposure to 1%. We suspect that some of these parameters may be due to poor performance that came from some more transitional floating-rate CMBS pools, which usually contain three to 30 transitional properties. The 1% restriction may unnecessarily restrict the market from utilizing products such as single-borrower CMBS, which was the first type of U.S. CMBS deal to re-emerge after the financial crisis, and currently remains a significant portion of the U.S. market (about 33% of 2015 issuance year to date through July). So, it is somewhat ironic that the transparency achieved in single-loan CMBS is excluded by regulatory rules that take comfort in diverse ABS pools.

Average Daily Trading Volumes: How is Liquidity Being Measured?

Any comprehensive measure of market liquidity requires many variables, such as bid/asked spreads, spread volatility, total outstandings, the ability to transact in times of market stress (such as right after the financial crisis), trading volumes etc. Unfortunately, all of those variables are not publicly available , which creates a challenge for regulators to analyze and implement a national classification system consistent with other different international markets. In charts 1 and 2 we compiled average daily trading volumes for various fixed-income products.

Chart 1 shows that agency MBS is the most liquid bond product traded in the U.S. by a wide margin, except for Treasuries. This explains investors’ concerns that it is classified as level 2A and haircut at 15%. While bid-asked spreads for corporate and municipal bonds are also consistently quoted by many market makers, the volumes are nowhere near the magnitude that can be traded in the agency market.

Because of the limited overall liquidity during the 2008-2009 crisis, many investors turned to other securitized bonds products such as CMBS, as many market makers were still able to transact among accounts in large amounts in these products, albeit at wider spreads. For CMBS, this created a record of widening historical price transaction levels, but given the volumes involved, that record actually indicates that liquidity was available in a functioning marketplace. Looking at the available data since 2011 (see chart 2), CMBS clearly remains one of the more actively traded and liquid structured finance bond sectors, with average trade volumes usually exceeding $1 billion on a daily basis. The shorter duration ABS products, such as credit cards or autos, have very low trading volumes because those investors usually buy to hold for the two- or three-year term, and so market makers may be less prepared to make markets in those bond classes. As a result, and because of their shorter terms, these bonds are less likely to see price distortion. The question still exists as to whether these assets are as liquid as a super-senior CMBS class that did see bids during crisis conditions. The overall high trade volumes for CMBS are likely to come mostly from the highest-rated classes, as many investors use those classes as a swap spread or yield substitute, which suggests that the most senior class could be a potential candidate for level 2B LCR treatment, similar to the ABS/RMBS products included in the EU regulation.

Further Clarity and Research May Be Warranted Before Final Implementation

Overall, the trading data and market sizes that we were able to examine suggest that the classification systems and haircuts are generally appropriate, but may need to be further researched and enhanced before being fully phased in. One particular topic that may need to be addressed is the differences in rules by jurisdiction because these new rules will likely influence global investment decisions and which formats of financing will continue to be available to borrowers in various markets. The current international proposed rules appear to favor some bond products while disfavoring others, and thus we may see further adjustment before final implementation to avoid unintended consequences. The Federal Reserve’s proposal to include certain municipal bonds as level 2A HQLA in the U.S. regulations is one example of an adjustment currently under consideration.

Endnote: We used the following sources for this piece: “Liquidity Coverage Ratio: Treatment of U.S. Municipal Securities as High-Quality Liquid Assets,” by the Federal Register, published May 28, 2015; “Criteria For Identifying Simple, Transparent And Comparable Securitisations,” by the Basel Committee on Banking Supervision, Board of the International Organization of Securities Commissions, published July 2015; and “EBA Discussion Paper On Simple Standard And Transparent Securitisations,” by the European Banking Authority, published Oct. 14, 2014.